5. Tax and Regulation

5. Tax and Regulation

There are two main ways that democracies interfere with pure free trade. The first is tax: the state forcibly takes money from people. The second is rules (often called regulation).

Tax is easy to see, since it involves the transfer of money. It is also easy to measure and to compare.

Regulation is harder to see: a rule which says that people must be paid twice as much if they work on Sundays has an indirect effect on the economy which is harder to see. Many regulations have an obvious benefit, and a hidden cost. For example, paying twice as much to Sunday workers is good for those who have jobs on Sunday [this is an actual policy in Australia at the moment]. The hidden costs is the businesses who don’t open in Sundays or who open for less hours on Sundays because workers are too expensive. This means there are people who would have got work if Sunday pay was normal, but instead of getting twice as much, they get nothing. This costs is less obvious because we can’t directly say which people didn’t get a job which doesn’t exist. Another hidden cost is preventing shops from opening on Sunday, which was a long standing Australia rule until the 1990s.

[In Australia, double pay for Sunday work is known as a “penalty rate”, and in this case the name gives it away: it is a “penalty” on the employer for choose to employ someone. Despite that, there is still strong support]

Often, a good way to see the hidden cost of regulation is to apply “reductio ad absurdum”: if a 200% tax for Sunday work is “good” for low income works, then surely a 300% rate is better, and a 1000% rate even better still. These are logical conclusions, yet it finally becomes obvious to even the most obstinate that penalty rates impose a cost of lower employment. We can next ask: why is 200% the correct rate? It is an arbitrary figure, without any logical justification.

We will examine the hidden cost of regulation later.

Each OECD member follows broadly the same system, but there are differences which means we can look at each country as an experiment in how much free trade purity there should be. A simple way of measuring this is to look at how much tax is collected by the state each year (where “state” means all the levels of government in a country).

In general, the share of production taken as tax is growing, and it is mostly between 25% and 35%. This means the government sector is very large, even in market economies. However, in some counties comparable to Australia, the tax share is stable over the past 50 years.

There are limits to how much tax and regulation a democracy will bear. The first point is that tax and regulation causes “harm” to certain voters (such as tax payers) while it brings benefits to other voters (parents benefitting from state education, pensioners, people who need medical attention, public sector workers, for example). Of course, many people are both taxpayers and beneficiaries of government services. Each voter tries to weigh up if they want to pay less tax or receive more services. The ideal is to get someone else to pay the tax while you receive the benefits, but since policies can not be tailored to individual taxpayers, the electorate is forced to make bigger compromises; rough groups of similar tax payers emerge, such as parents of young children, pensioners, blue-collar workers, public-sector employees, people wanting to buy their first home. Sometimes people talk about other grouping, but grouping by economic interest is very strong.

A moderating force is that many people will take a lifetime view: parents will consider policies that benefit their children even if they don’t have much benefit to them. A young person just starting their career may not have much money, but may aspire to be wealthy later in life. They will be more sympathetic to policies favourable to the wealthy than you would expect based on their immediate situation. The idea that people can move “up” is called social mobility, and it seems to be a very important part of a well functioning market democracy.

Regulation is also a factor, as well as tax. One example: In some countries, such as Spain and France, there are very strong protections for people who have full time jobs. An employer may need to pay several years of wages and follow a long process to dismiss an employee, and because of the cost, substandard employees will continue to be employed (and employees have little incentive to learn new skills and increase their contribution to the business, or meet changing needs). This slows down the growth of the firm and slows down employee turnover, both of which are the reasons for very high youth unemployment in these countries. The rules very strongly benefit those in jobs, but harm those looking for jobs. Interestingly, young people who are unemployed sometimes protest against these laws being changed, because they hope one day to have a job which is as protected as their parents; it appears they will endure a long period of unemployment to win a payoff of job from which they can never be dismissed. I believe that these young people do not understand the harm caused by the job protection laws, either because they don’t understand basic economics, or they don’t trust the proponents of reform. The ability to build trust around economic reform is one of the great achievements of the Hawke/Keating era of Australian governments.

Economics exists to inform us of when tax and regulation brings benefits and when it causes harm. Broadly speaking, after a certain point, higher taxes and increased regulation cause low growth and high unemployment, which tips a majority of voters towards a “reform” process. The Hawke/Keating government in Australia (1990s) is one of the best examples of this being a good process. The crisis in Greece since about 2012 is a good example of this process being a disaster, in which the political system refused to tackle reform. Disaster struck. With lenders having lost all confidence that the Greek political system could reform, reform was imposed.

The characteristic of the Australian experience is that it was lead by government; the characteristic of the New Zealand and Greek experiences is that the process of reform was forced due to economic emergency, because reform was not taken in time.

Trends in tax collection

So we see that there is strong support for a certain amount of government tax and regulation, yet it goes in cycles: taxes and regulations have negative effects when they get “too” high, and a reform happens. But people disagree about what “too high” is. Economists disagree too. Economic systems in the real world are very complicated. A simple model lets us change only one thing and see what happens, but in the real worlds, many things are changing at the same time, so it can be unclear what change caused what outcome.

But if we treat the OECD economies as a natural experiment is different settings for tax and regulation, we can see some broad links. A simple question we can ask is: is the average amount of tax being collected going up or down?

Overall, we see an increase in tax collection (and government spending) according to the average of OECD countries. This is probably mostly caused by aging populations, which need more care. Countries with population growth will tend to have lower tax levels because the average age is lower. More people are working, and less people need expensive medical care: this is a huge benefit of immigration. Countries which seem similar to Australia, such as Britain and Canada, have tax takes in 2015 which are not much higher than 50 years ago. France has taken a different path, and seen sustained increases in tax. The French state is very large, and the economy is highly regulated (compared with Australia or Britain).

Countries which are in rapid economic development show a very fast growth in the role of the state. In the chart, Korean is an example of a economy which has moved rapidly into a rich-world market economy. Korean was accepted into OECD membership in 1996 (on my birthday). We can see that even as its economy grew fast, the share of tax revenue increased even more, which means there was a rapid increase in the government sector (the government sector would have grown fast even if tax share remained constant because of the growth in the economy). It seems that Korean voters aspire to the larger government sector we see in rich countries. I believe this will always be the case. Democracy is empowering for groups who don’t have the power which controls autocratic systems (such as Korea before it became democratic).

Some benefits of the government sector are long term. One example is interfering with the market to prevent pollution, or to raise taxes to pay from schools and scientific research, or public health campaigns such as reducing smoking. These are examples of good reasons to interfere in the pure market.

Sometimes, the costs of interfering punish everyone a small amount, which is a very large total effect, not but very visible to any individual, but bring large benefits to a small group. These are often bad decisions. The hidden costs of regulation are covered later.